Merger costs to plummet--on paper

Accounting rules to boost earnings, investor confusion

The holidays may be the time for goodwill toward men, but next month it's shareholders' turn--and this kind of goodwill may bring little joy.

A new accounting rule goes into effect for scores of companies Jan. 1 that will goose corporate profits by allowing companies to keep some big acquisition costs out of the equation when calculating their quarterly earnings.

The change will mean billions of dollars more each year in corporate profits, with only the stroke of a pen, because companies will no longer have to write off over several years their goodwill--the difference between what a company paid for an acquisition and what its hard assets are actually worth.

For many companies, this will bring a substantial jump in 2002 quarterly earnings. For many investors, it could bring a healthy dose of confusion.

AOL Time Warner Inc. announced its reported net income would surge by nearly $6 billion because of the change. The media and entertainment powerhouses completed one of the largest corporate mergers in history early this year.

Acquisitive General Electric Co. said the move will add 11 cents a share to earnings in the first quarter, mitigated by lower returns in pension plan assets and other factors.

All of that is great news in a year when corporate profits have been hammered by recession, except for one problem: It doesn't add any real corporate wealth.

In addition, critics say, it can lead to misleading comparisons, depending upon how prominently companies report their year-earlier results as adjusted for the new standard. With many analysts pointing to the potential for easy year-over-year comparisons because of 2001's dismal earnings results, the goodwill rule could paint an even rosier, if potentially misleading, picture.

The Financial Accounting Standards Board adopted the rule in June; companies had argued that the intangible assets they acquired could of course be more valuable, not less, over time.

But the new provision requires companies to regularly test whether goodwill on the books has substantially declined in value. If it has, they must write down its value, which in many cases runs into billions of dollars.

In the wake of the dot-com and telecommunications meltdowns, it could mean some stunning admissions by corporate managers that they vastly overpaid for acquisitions in the boom period.

It's happening to some already. JDS Uniphase Corp. has already announced a huge writedown of $38.7 billion in goodwill for its acquisitions. Similarly, Nortel Networks Corp. took a $12.3 billion after-tax charge in the second quarter, primarily to write down goodwill from acquisitions.

The new accounting rule could also mean more scrutiny for the accounting watchdogs, already reeling from some high-profile errors. The goodwill rule requires companies to make a fairly subjective call about whether their assets have declined in value--potentially a big boon to valuation experts and a big headache for corporate executives.

"A number of companies will attempt to do this in-house, but there's always the fear that the SEC will come in and ask why they didn't have an independent third party verify it," said Douglas Rogers, executive vice president of CBIZ Valuation Counselors in Chicago.

Rogers is predicting a last-minute corporate dash to comply with the new rules, and sees a potential minefield ahead.

"The whole point [of the new rules] is to accurately reflect the impact of deals. If you overpay and have a lot of goodwill in one unit of your company, chances are you're going to have a big impairment charge," he said.

The change requires companies to test business units separately to assess their fair value, which gets complicated for companies in several lines of business, Rogers and others said. That could lead to differences in recording values among companies, which makes it more difficult in the end for shareholders to decipher as well.

Firms are also realizing that these reviews will be costly at a time when revenues are also slower, essentially adding another layer of auditing onto the company's docket.

"A year ago people said this was going to be great," said Jim Somers, a partner in Chicago with accounting firm Ernst & Young. "Now they realize this impairment review is going to be costly and it's one more thing to audit."

Corporate executives had been salivating over the change because it allows them to consummate big mergers without having to tell shareholders to expect big charges for amortization. Now, it could trigger some pretty stunning confessions about the deals recently done.

"The timing could have been better," Somers said. "There are a lot of companies out there with a lot of goodwill and little market capitalization."